I Can't See Major Market Reversal Before Dow Reaches 10,000

At Davos, Professor Nouriel Roubini declared that US banks were insolvent. On 14th March he declared that the incipient US stock market rally was a "dead-cat-bounce-..." that would be overturned by the terrible economic prospects.

Last time I looked, the Dow was up almost 30% on 9th March, which puts it well out of normal dead-cat-bounce territory (the "bounce" is typically dictated by how far they fall.

And "Hallelujah", the Stress Tests have confirmed "beyond any reasonable doubt" that Secretary Paulson was absolutely correct when he announced to an adoring public in July 2008 that "the US banking system is safe and sound".

Well actually, as Lord Cooper's aide used to say in Evelyn Waugh's classic "Scoop", "Up to a point!" (see article here).

The "doomsayers", (and there are many) point to (a) P/E ratios (going down to 4,000) (b) the lousy economic prospects, (c) insider selling, (d) the still stinking banking system, (e) creative accounting, and... (Phew!)...(f) corruption and crass incompetence in high places, (and they say this HAS to have an unhappy ending).

I don't have an argument with most of that, except perhaps the "answer"; I'm not so sure that there will be an unhappy ending...haven't we had enough of those for one crash?

Perhaps there is a limit to how much damage you can do to an economy, even if you try real hard - look at Somalia, a failed state. But the Wall Street Bankers can only sit in silent admiration and marvel at how creative young entrepreneurs have figured out bold new ways to rip people off (of course that's just a cottage industry compared to Wall Street - what they need is some organization and a few lobbyists and then do an IPO).

Anyway, as it floated higher the rally got incrementally downgraded to a "sucker" then a "bear" then what...a "chump"?

Now there is apparently a legion of investors scratching their heads and holding their breath, waiting in strained anticipation for the next thing they don't understand to bite them in the backside.

But Professor Roubini is always right...RIGHT!

Well, up to a point. This chart compares the size of reversals over 15% for the DJIA since 1929 with the extent of mis-pricing (mis-pricing is explained here).

click to enlarge

So for that limited amount of data the extent of mis-pricing appears to be a reasonable predictor of the size of the reversal (I treated the recent reversal as part of the Dot.com reversal, i.e. as an outlier - I don't regard deliberately shooting yourself in the foot as a typical "market" phenomena).

However if the 88% reversal from 1929 to the eventual bottom three years later is taken out there is not a good predictor relationship (33% R-Squared is about random; although there is a range - only 5% chance of being outside the dotted line).

Anyway, market-long-wave analysis says that for DJIA breaking 10,000 in 2009 it will be 37% to 42% mis-priced (below); and that's for worst case nominal economic growth of minus 4% in 2009 and let's say worst case the 10 Year Note goes up to 4.5% from now (as the men in suits with their hands deep in the US taxpayers pockets try and raise more trillions - I won't discuss what they are holding in those hands).

And the downswing predicted from the previous upswing is 42%, so that looks about the bottom in mis-pricing on the downside to me.

Looking at the chart, it appears there has never been a major reversal of the DJIA (i.e. greater than 15%) when the mis-pricing was more than 10% (under), so regardless of the impeccable logic for why this was a sucker-dead-cat, I just don't see a reversal coming any time soon.

Looking at that another way, the extent of reversal compared to the history with the diameter of the rings sized to represent the extent of reversal:

This chart illustrates that reversals typically seem to happen when the market is mis-priced above the estimated "other-than-market", which intuitively makes a lot of sense.

Also, the size of the reversal appears to be broadly proportional to the speed at which the market went out of equilibrium and over 45 years when the market was mis-priced under.

Only three reversals happened when mis-pricing was negative and in each case the line was moving up towards zero, minimum was 10% mis-priced. That compares to twelve major reversals in the 45 years it was mis-priced over.

So right now, if indeed the Dow is about 40% mis-priced under, for it to be 10% mis-priced it will have to reach 14,000 this year which would be a bit of a stretch (history suggests it's going to bumble along in the range -30% to -45% for the next year at least).

So where does this leave the sucker-dead-cat-bounce rally, downgraded to a chump-rally?

My view from looking at that data, and assuming that the bankers are not going to manage to screw things up in 2009 as badly as they did in 2003 to 2007 (i.e. "no more surprises or super con tricks this rip-off-and-run season"), then it's highly unlikely that there will be a significant (more than 15%) reversal in the DJIA (and the S&P 500 correlates with that), certainly not worth breaking into a sweat over until the DJIA goes through 10,000.

If there is, well, I'll ring the neck of this darn cat that's been sitting on my lap since early March and barbeque it.

Disclosure: No Positions

Comments

[Andrew Butter:]

Delighted to have brought some sparkle to your day.

I don't recall saying everything was peachy in DC and WSt, rather the opposite.

My point is simply that I believe the markets have priced in the bad news.


On May 12 09:38 AM Beach Bubba wrote:

> Bwah, hah hah. I need a good chuckle now and then....this guy is
> a comedian.
>
> Yeah, everything is just peachy....couldn't be better in DC and WSt....what
> planet does this author live on.

May 12 01:04 PM

[Andrew Butter:]

I understand your sentiments.

Have a look in six months time and tell me if I was guessing.


On May 12 10:02 AM Larry House wrote:

> A lot can happen whether you can see it or not. There is no way
> to look at data, etc. and pick a number out of a hat. Just guess
> work.

May 12 01:06 PM

[Andrew Butter:]

Yeah well we disagree, the more I look the more I think this is just same old same old, but the sentiment is valid

I think the "uncharted" argument is dangerous, what happened was predictable, what went wrong was that people said that house prices going up forever was "uncharted waters", well it wasn't.


On May 12 10:41 AM Jimbo wrote:

> The more I look at our current situation, the more uncertain I become.
> I sense that we are truly in uncharted territory.

May 12 01:09 PM

[Andrew Butter:]

I agree completely.

You might be interested to read what I wrote about the architecture of America in

www.marketoracle.co.uk...


On May 12 12:21 PM sickofthehype wrote:

> Yes you're right, the oil we consume is completely related to SUV's.
> Guess those of us with families and pets to haul around should be
> doing it in a Prius right?
>
> Look at the rest of the globe - high efficiency clean diesels achieving
> double the mileage of the comparable car, truck, and SUV in the US,
> but does the US have them? No. And why? Ask your government why.
>
>
> The capability has been there for quite some time, but the greedy
> bastards in charge keep things the way they are for a reason - their
> own profits.

May 12 01:11 PM

[nyoneway:]

May I add that the bubble was fueled by Real Estate and (almost) everyone ate well during the boon times. This downturn is not caused by banks going busts, rather, it's the assets they held that went down in value.

The health of banks are just a reflection of the state of the economy.

On May 12 01:01 PM Andrew Butter wrote:

> I agree this is not a normal downturn, it was caused by the banks
> going bust, that was nothing to do with markets, it was incompetence
> -plus fraud.
>
> That's why I ignored the recent drop in the analysis, my point is
> simply not that there is not very bad news, just I believe the market
> has now priced that in.
>
> I agree that extraordinary economic damage will be caused by the
> borrowing to mend the mistake that was made and that ordinary Americans
> will pay for that for generations,
>
> If there is a message in my essay it's stop throwing money around
> and let the capitalist free market economy fix itself.
>
> I believe it can - once the government gets out of the way.

May 12 02:13 PM

[altaman:]

The tune:

"The sun'll come out Tomorrow
Bet your bottom dollar
That tomorrow There'll be sun!"

The author's reality: "Disclosure: No Positions"

My conclusion: "I do not appreciate convictionless pumpers!"

May 12 03:39 PM

[Fred Voetsch:]

I have a great nose for bad data and this stinks to high heaven. For one it's overly complicated. What you are suggesting should be simple to explain but you make it very complex and that is a sure sign that there is bad data somewhere along the line.

I have a simple program that calculates the trend average of the DJIA going back to 1900. It's a very simple program but if I don't feed it the right data it can eally lead me astray.

The problem with your data is that the stock market was more overvalued in 2000 than in 1929 and then in 2007 got back to about the same state. Your chart suggests that the market was only 77% "overpriced" in 2000, which is wrong, based on any and every metric one uses. Book value, P/E, trend average....

You then have the market underpriced in 2007, which is just absurd. Are you using P/E? If so, do you take into account that earnings were built up over DECADES by leverage that would HAVE to be deleveraged just as in the early 1930's? Of course not.

But let's get back to a tren average because you can base your valuations on anything so I could never convince you. To calculate a trend average you should use crashes as a measuring tool throughout history to indicate "balance points". For instance, crashes don't always happen when the market is at a certain level but when a crash happens the crash will do its job and correct PAST the level of fair value. Look at 1973-74, 1987 and of course the early 1930's. These are points through which you should run your trend average and what you come up with is a very consistent 4.8% annual increase in the DJIA from 1900 starting at 36. 36 is a halfway "balance point" that very accurately marks a fair starting point. Multiply that by 0.048 each year and you see that the trend runs exactly as expected right up to now...when the trend average (fair value) stands at 5951.

Check it!
www.acclaimimages.com/...

You'll see the trend average run right through the middle of crashes and corrections year after year and decade after decade. You'll see that the 40's and 50's were under trend value and the the 60's went a bit over and then the 70's went way under and by the 90's we had gone way over right up until 2000 when we were more overpriced than at any time in history. There's your mistake. If your 77% is wrong (it is, and by a wide margin) then your entire argument is wrong and completely worthless.

You have the single most important point of data wrong and on top of that you have made a simple matter very complicated. One can simply look at stock charts and see that there is no reason why the market should not stop here and reverse, go sideways for awhile, or go up, if that's what the market needs to do. This attempt at providing "data" to predict the future is one of the worst I have ever seen.

May 12 04:36 PM

[Fred Voetsch:]

Wow...the more I look at this the more I think this is the worst piece of work I have seen in a long time. Notice the top chart that states, "33% if omit 1929"...big mistake, my friend.

Wow...

May 12 04:41 PM

[Fred Voetsch:]

I think my first response to this was a bit long but if you want an absolute 100% visual of what's wrong with this "data" just look at the DJIA Log Scale graphic and notice that even in 1932 he does not have the stock market as underpriced.

...today it is?

The baseline is just so wrong it screams! Ouch! BAD DATA! BAD DATA!

May 12 04:53 PM

[Andrew Butter:]

% miss pricing in Black line - and LEFT hand scale

DJIA is Blue line - (put in simply for comparison) - RIGHT hand scale


On May 12 04:53 PM Fred Voetsch wrote:

> I think my first response to this was a bit long but if you want
> an absolute 100% visual of what's wrong with this "data" just look
> at the DJIA Log Scale graphic and notice that even in 1932 he does
> not have the stock market as underpriced.
>
> ...today it is?
>
> The baseline is just so wrong it screams! Ouch! BAD DATA! BAD DATA!

May 12 06:00 PM

[Andrew Butter:]

I think 1929 was an important event in the history of DJIA, so I prefer to use the 78% R-Squared

Although the logic still holds if you don't and you use 33% - the probability of being outside the dotted line is 5% (nothing to do with the slope of the line)


On May 12 04:41 PM Fred Voetsch wrote:

> Wow...the more I look at this the more I think this is the worst
> piece of work I have seen in a long time. Notice the top chart that
> states, "33% if omit 1929"...big mistake, my friend.
>
> Wow...

May 12 06:04 PM

[a. palmer jr.:]

I think I'm gonna try to find one stock in my portfolio that I can make a little money on first before I buy any more. I bought mine fairly cheap but they went down even further. They're still not back up to what I paid for them...and another thing, when are the dividends going to go back up where they were?

May 12 09:06 PM

[CJJ:]

Its shocking how someone can obviously not have read an article and then comment. I have no problem with it, I'll even do it, but at least I'll admit I just don't like the author.

The article is not stating that all is well. Its stating that a drop from 14500 to 6500 that goes back up to 8500 is still a aggragate drop of 6000 points!!! and perhaps some people have forgotten that.

I'm not sure when people started looking at the stock market as a point in time mechanism. Its laughable.

For what its worth I think anyone who makes predictions on where the stock market or markets in general are going are picking at straws in the wind. Up or down, no one can know for sure...but why some people are rooting for huge moves down really confuses me.

On May 12 03:39 PM altaman wrote:

> The tune:
>
> "The sun'll come out Tomorrow
> Bet your bottom dollar
> That tomorrow There'll be sun!"
>
> The author's reality: "Disclosure: No Positions"
>
> My conclusion: "I do not appreciate convictionless pumpers!"

May 12 10:40 PM

[one eye:]

MoneyMap has a similar graphic but has not issued a buy signal as yet. Your 10,000 will be a minimal target when it does.

May 13 02:09 AM

[Andrew Butter:]

Three bad assumptions were made (a) house prices would go on going up forever (b) the ratings agencies could accurately forecast risk of them not (c) you could insure the risk that they wouldn't. It's a classic "hang-off" screw up, everyone thought someone else was watching the ball.

I don't think they will make that mistake again any time soon.

My concern is that bankers exist in two quantum states - (1) extreme greed, and (2) mortal terror.

Now they are in state (2) and if anything are probably being too conservative in their lending, and why should they take risks any more? They get their raw material basically free, so they can make huge margins without taking risk.


On May 12 06:49 PM WAKEUP wrote:

> Who knows? I am curious about one thing, though: What makes you think
> the bankers can't screw up again, just as badly? Screwing up, even
> worse, is just the kind of challenge our bankers relish. No faith,
> I hear you saying? That's right; no faith, at all, in these guys,
> other than in their ability to make wrong-headed, lame-brain decisions.

May 13 08:06 AM

[Andrew Butter:]

My analysis is long term (my background is real estate, when I look at a project I look 5 to 10 years) and I'm not offering investment advice.

I'm offering an opinion and an analysis that I think is interesting.

In my opinion now is a good time to buy the market if you are looking for a decent return over the long term, my advice it's not particularly aimed at trader.

But that's just my opinion, I explain my logic and people can decide.

Part of the reason I post is simply so that I have the "prediction" in the public domain so I can go back in six months time and say, "look the analysis worked."

I have only ever made one other prediction on the stock market where enough time has passed to (perhaps) proved me right, which was in January 2009 when my model said that the Dow would go down "below 6,600" - that seems to have been right, I would be very surprised if it's not right.

If you want to follow my ideas, best thing would be to check in six months time, and if I was right well...

But I do think that the 98% of commentators on SA who are warning of a bear, are not correct. Time will tell.


On May 12 09:06 PM a. palmer jr. wrote:

> I think I'm gonna try to find one stock in my portfolio that I can
> make a little money on first before I buy any more. I bought mine
> fairly cheap but they went down even further. They're still not back
> up to what I paid for them...and another thing, when are the dividends
> going to go back up where they were?

May 13 08:20 AM

[Andrew Butter:]

I don't understand why everyone says I should have a position to do analysis.

I am an analyst, what I do is valuations and that's how I make a living, I am completely up-front that this is the first time I have done a valuation of stock markets, I have a model, if you find the logic interesting great, if not great too.

My position is that I got out of real estate and got my clients out before the crash and I am studiously doing nothing in the area that I am an expert.

My position is a grid reference.

If in six months time my model turns out to be valid, then I might start to take positions, but if i do I won't be writing about it.


On May 12 10:40 PM CJJ wrote:

> Its shocking how someone can obviously not have read an article and
> then comment. I have no problem with it, I'll even do it, but at
> least I'll admit I just don't like the author.
>
> The article is not stating that all is well. Its stating that a drop
> from 14500 to 6500 that goes back up to 8500 is still a aggragate
> drop of 6000 points!!! and perhaps some people have forgotten that.
>
>
> I'm not sure when people started looking at the stock market as a
> point in time mechanism. Its laughable.
>
> For what its worth I think anyone who makes predictions on where
> the stock market or markets in general are going are picking at straws
> in the wind. Up or down, no one can know for sure...but why some
> people are rooting for huge moves down really confuses me.
>
> On May 12 03:39 PM altaman wrote:

May 13 08:27 AM

[Andrew Butter:]

Thanks for the reference.

I thought I was the only person looking at markets this way (VectoVex looks short term and their analysis is similar). But I will have a look.

I can't recall saying "buy" all I said was exactly what I did say, I'm not offering investment advice, if I did that I would be sending a bill and asking for a carry.


On May 13 02:09 AM one eye wrote:

> MoneyMap has a similar graphic but has not issued a buy signal as
> yet. Your 10,000 will be a minimal target when it does.

May 13 08:32 AM

[Misha Bloom:]

Developing a viewpoint using recent historical data is appreciated. Do you think this is justified given the fact that unprecedented levels of US assets & debt are foreign held?

May 14 04:08 AM

[Andrew Butter:]

Money is money.

I think an interesting point there is that one argument for the potential decline in the markets is that the baby-boomers age getting old, possibly not valid.


On May 14 04:08 AM Misha Bloom wrote:

> Developing a viewpoint using recent historical data is appreciated.
> Do you think this is justified given the fact that unprecedented
> levels of US assets & debt are foreign held?

May 14 10:49 AM